National Institute of Economic and Social Research

Friday, 27 January 2012

Fiscal policy: what does "Keynesian" mean?

On Sunday, David Smith described me as “a former Cabinet Office economist who has
taken the institute [NIESR] back to its Keynesian roots”. Then on Wednesday, Nadhim Zahawi MP talked of
“Keynesians such as [Ed Balls] and bodies such as the NIESR”. This prompted a couple of thoughts. What do they
mean? And am I, in fact, a Keynesian? So I
emailed David Smith to ask. He hasn’t replied yet, but, as I pointed out
here, in fact on the point he was disputing with me (why are UK long-term interest rates so
low) my views are clearly simply the standard (pre-Keynes) rational model of
interest rate determination. Mr Zahawi's statement is in reference to a quote (also cited in my blog here of the same day) from the IMF World Economic
Outlook update:

“Among those countries,
those with very low interest rates, or other factors that create adequate
fiscal space, should reconsider the pace of near term fiscal consolidation.”

So
presumably he thinks that those of us who agree with the IMF on this are "Keynesians". More of that later.

But first, since this is to some extent
personal, some autobiography. I joined the Treasury in 1987 – as a generalist,
with a Maths degree, not an economist – and learned my economics, both macro
and micro, on the job, culminating in a stint in the Chancellor’s (Norman
Lamont’s) office. I worked both for Nick
Macpherson, now the Permanent Secretary of the Treasury, and Jeremy
Heywood, the new Cabinet Secretary.

Then in 1992 I decided I did in
fact need some formal training in economics, and I went to Princeton, where I
studied macroeconomics first with John Campbell (primarily a financial
economist) and then Ken Rogoff, who went on to become Chief Economist at the
IMF. Both were very much in the mainstream of modern macroeconomic thinking. After that, I had a varied career, but didn’t really do much
macroeconomics until I ended up in the Cabinet Office on the eve of the
financial crisis.

At no point in this period did I think of myself as a “Keynesian”. Nor was it really a meaningful question. You might as well have asked a physicist if he was a “Newtonian”. Keynes was a great figure (indeed, one of the greatest Britons of the 20th century) and you had to understand his insights to understand macroeconomics; but the debate had moved on. The Treasury approach to macroeconomic management throughout this period was that while fiscal policy mattered, it wasn't - for largely pragmatic reasons - sensible to adjust policy in order to manage demand; monetary policy was quicker, more transparent, and less subject to political distortion. And I fully subscribed to this view.

Of course, post-2008, things are
rather more complicated. So what could
it mean to be a “Keynesian”? I can
think of a number of possible definitions.

1.
Going back to the 1930s, Keynes himself obviously defined himself in
opposition to the "Treasury View" [sometimes also described, somewhat
unfairly, as "Say's Law", that supply creates its own demand], that fiscal
policy cannot, as an accounting identity, impact aggregate demand, because the
government needs to get the extra money from somewhere, whether through taxes
or borrowing. So a Keynesian is anyone
who doesn't believe this identity means that fiscal policy can't impact demand.

This appears to be the definition espoused at one point by John Cochrane at the
University of Chicago, who wrote:

"First, if money is not going to be printed, it has to come from somewhere. If the government borrows a dollar from you, that is a dollar that you do not spend, or that you do not lend to a company to spend on new investment. Every dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both . This form of “crowding out” is just accounting, and doesn't rest on any perceptions or behavioral assumptions."

This became the subject of a
furious row in the econo-blogosphere, with Paul Krugman, Brad Delong and Simon Wren-Lewis accusing Cochrane of "undergraduate errors". Cochrane himself seems to have retreated from
this position, as Delong and others have pointed out. But leaving US academic disputes aside,
obviously in this sense I am a Keynesian - hence the title of this blog! But then so is everybody else, including
today's Treasury. Nobody, and I mean nobody, really believes that it is
impossible by definition for fiscal policy to affect aggregate demand.

2.
A more plausible, and traditional, definition is to say that a Keynesian
is someone who believes that as an empirical matter, fiscal policy does have a
substantial impact on aggregate demand; in contrast to those who believe that
"Ricardian equivalence" means that changes to government spending and
borrowing will be substantially or wholly offset by changes to private sector
spending and saving. More recently, the
doctrine of "expansionary fiscal contraction" went even further, and
argued that tightening fiscal policy could, through exchange rate and
confidence effects, actually increase demand and growth; a paper by Alesina and
Ardagna was particularly influential in this respect, and even
(tentatively and briefly) influenced the Treasury here, who argued in the 2010 Emergency Budget that

"These [the wider effects of fiscal consolidation] will tend to
boost demand growth, could improve the underlying performance of the economy
and could even be sufficiently strong to outweigh the negative effects".

The Treasury has not as far as I am aware repeated this argument,
although Mr Zahawi apparently still believes it, arguing:

" I am well aware
of the fiscal multiplier effect of such strategies, but there is growing
evidence that in a debt crisis it is less effective or simply doesn’t work."

But he is rather behind the curve on this, since the evidence shows precisely the opposite. The
original paper has been widely questioned, debunked by further IMF research, and (more importantly) experience has
hardly verified its claims. The
conventional wisdom now is very much that of the IMF, which by October 2010 had
already concluded that:

"Fiscal consolidation
typically lowers growth in the short term. Using a new data set, we find that
after two years, a budget deficit cut of 1 percent of GDP tends to lower output
by about ½ percent and raise the unemployment rate by ⅓ percentage point."

Coincidentally, these results are quite similar to those given by NIESR's model
for the UK. The IMF has if anything strengthened its views since,
with the current Chief Economist saying recently:

"[fiscal consoliation] is
clearly a drag on demand, it is a drag on growth."

So I'm a Keynesian on this definition,
but then so too are the Managing Director and
Chief Economist of the IMF. And so
indeed too are the Treasury, Bank of England, and the Office of Budget Responsibility. Like the NIESR model, their models too incorporate a fiscal multiplier; and I do not think that senior
officials at any of these institutions would deny for a minute that fiscal
consolidation has, in practice, had a negative impact on growth in the UK. For example, the Monetary Policy
Committee said in November 2011:

"Growth
had been weak throughout the past year, reflecting a fall in real household
incomes, persistently tight credit conditions and the effects of the continuing
fiscal consolidation. "

This is no longer
a contentious proposition, Mr Zahawi notwithstanding.

3.
So under definitions 1 and 2 I'm a Keynesian, but then so is pretty much
everyone else who one would take seriously.
The final definition, then, of a Keynesian, appears to be a much more "political" one - someone who
thinks that slowing fiscal consolidation would be a sensible policy decision in
the current UK economic context. This does at least make David Smith's and Mr
Zahawi's comments meaningful, since clearly I do fall into that category and
those currently responsible for UK fiscal policy don't.

But this definition seems to me to be misconceived, for two reasons. First, if
"Keynesian" means anything, it must surely have a more general
significance than indicating one's position on a particular policy choice in a
particular country at a particular time. Surely it should indicate a philosophy, a theoretical view, or
at least a view of what the empirical evidence means?

Second, and perhaps
more importantly, it is quite clear that - now that the "expansionary
fiscal contraction" hypothesis has been discredited - the main argument
between those of us who favour slowing fiscal consolidation in the UK and those who think that this would be a
dangerous mistake is not about whether the direct impact would be positive. It is
whether the price of this direct positive impact would be "credibility" with financial markets, and hence a damaging rise in long-term interest rates that would more than offset the gains.

I think this risk is hugely exaggerated, while the damaging social and economic consequences of inaction are correspondingly not recognised (see here and here), but the point here is not who's right, but that this debate really has nothing to do with Keynes at all. It's about a lot of things - how policymakers should deal with potential market irrationality, the role of the credit rating agencies, multiple equilibria, etc. But I don't see that taking one side or the other of these arguments makes you a Keynesian (or not).

Finally, and returning to what I originally learned at the Treasury, there still remains the view that if we think demand is too low, then the right response is always through monetary rather than fiscal policy. Again, there is a vigorous debate among blogging economists on this topic (see here for an introduction to the debate). And here my perspective has indeed changed; I no longer subscribe to the Treasury view of the last two decades, described above, that fiscal policy never has any role to play in demand management, even though I don't think it should be the tool of first resort. (See Simon Wren-Lewis' excellent discussion here, especially the penultimate paragraph).

But just as this approach was motivated by pragmatism more than theory - monetary policy was better suited to this task - my change of mind is similarly motivated. If monetary policy alone was indeed enough in practice, we wouldn't be where we are now, with unemployment a million higher than the OBR's estimate of the natural rate, and no prospect of it coming down in the immediate future. Any demand management policy that delivers that outcome is not one that policymakers should regard as remotely adequate.

So my views have indeed changed; not, I would argue, ideologically, but in recognition of the fact that life, and macroeconomics, is
considerably more complicated than we thought.
Again, this view is shared by the Chief Economist of the IMF, who argues:

"We’ve entered a brave new world in the wake of the crisis; a very different world in terms of policy making and we just have to accept it....Macroeconomic policy [specifically fiscal and monetary policy] has many targets and many instruments."

This
pragmatic and questioning - but evidence-based - approach to macroeconomic policy is one I
share. If he were here, I imagine Keynes
would too.

Want more? Further reading: a more academic, but complementary, analysis from Simon Wren-Lewis.

9 comments:

Nice post. Agree with much, although Keynesian should also include the financial side of his thinking, ref. instability of markets and need for public investments. But funny with these labels; just read interesting paper about Chicago school in the 30s (all "monetarist") who were strong advocates of fiscal stimulus (Viner, Douglas, Simons, etc.). Even Friedman was for fiscal stimulus (at least in this 1948 article). And, as chairman Eccles of Fed concluded in 1935, if you have excess reserves, monetary policy is "pushing on a string". Then fiscal policy is the only way to generate a recovery. We have indeed a lot to learn from that period. I think the early Chicago professors would have agreed with most of your stuff and ergo called themselves Keynesian. But with an ironic twist of history, just because of their pragmatic positions, they were never convinced by the mechanical US Keynesians, and therefore remained monetarists.

Very interesting as ever. A question, if I may. We continually hear from the Government that their policies have held down long term interest rates and that this is good for business. I agree with your analysis here and in previous posts that this is a piece of political obfuscation: rates on government debt might well not carry any significant risk premium (well done us, not so well done Greece), but once you get past that, low long run rates today implies negative market expectations for the economy tomorrow. So here is the question: is there any merit in the governments' argument that their role in avoiding an increase in the risk premium on UK gilts is helpful to wider economic growth? It seems to me that, if I were a UK business, the chance of a government default has little to do with price I will pay for my loan. I worry thought, that as a microeconomist, I've potentially missed a more macroeconomic mechanism that would give the governments' at least some cogency.

I think the short answer is yes. It's theoretically possible that if the government default premium rises, that has no impact on the corporate borrowing rate, but I don't think that's really how banks price loans; they price them off the gilt rate. Moreover, think of it this way; if govt default probabilities rise, so do bank default probabilities (if the govt goes bust so do all the banks) so banks' borrowing rates go up too, so with a constant spread they have to charge higher rates.

So I do think that avoiding a risk premium on govt debt is helpful to growth; it's just that, like you, I think there's a ways to go before we have to worry about that, and a somewhat slower pace of fiscal consolidation would have little or no impact on the risk premium.

Very helpful explanation, thanks. So Danny Alexander isn't a complete charlatan for making the argument. But it seems to me to be second order - financiability of the national debt is a function of the stock of debt rather than the size of today's deficit. Reducing the fiscal deficit today could have a first order effect on growth, creating more of a problem than a solution, e.g through a higher debt to GDP ratio.

"If monetary policy alone was indeed enough in practice, we wouldn't be where we are now"

You need a strong counterfactual for that, that is not an "empirical" view. Bank Rate was at or above 5% in 2008 up till October. The current ONS data has *nominal GDP* falling from Q2 of 2008. So monetary policy was doing the right thing in 2008, right? That's the empirical evidence?

"Any demand management policy that delivers that outcome is not one that policymakers should regard as remotely adequate"

Yup. And yet, HM Treasury delegates demand management to the BOE, and the Bank of England have been saying through most of 2011 that they are equally worried about demand growing too fast as too slow. There were MPC members voting for rate rises for half of the year.

So where is the criticism of vastly inadequate monetary policy? Why are you not calling for a different MPC mandate - or a different MPC?

I take your point as being that monetary policy should have been, or should be, much looser. My argument was not that this is necessarily wrong, per se, but that even a generally activist (and economically literate) MPC didn't deliver it, suggesting that in practice there are political/structural reasons why monetary policy can't take the strain. But I agree this is a subjective view.

No. You seem to conflate "the limits of monetary policy" with "the capabilities of the MPC under a mandate to target an inflation rate of 2%".

But the two are completely different things. Under a different mandate, why could the MPC not act differently? They are constrained by the inflation target - so change the target. They were saying all through 2011 that they COULD stimulate demand, but that they WOULD NOT because of the inflation rate.

And yet, we are supposed to wave this away as a mere curiosity, and call for more deficit spending by the... erm, economically literate George Osborne?

I'm not sure how really useful it is to label people, particularly given the complexity of Keynes' own views, but I guess it is the world we live in. If someone labels you, you have to fight back I guess. For what it is worth, I think most people, especially americans, use the label "keynesian" to mean "fiscal activist", rather than anything more abstract. Most people who use the label also have not, I suspect, come with ten feet of the General Theory.

I also just wanted to state my utter amazement at the Cochrane quote. He commits several conceptual errors in that paragraph, but the total confusion he exhibits as to the relation between macroeconomic stocks and flows, as well as the meaning of basic accounts, is just astounding. How can a very smart guy be quite so confused ? And he has no doubt taught this kind of shoddy thinking to generations of students.

My thoughts on this got a bit long (not to mention vague) for a comment, so I posted them at Another Canadian Economics Blog (http://anothercanadianeconomicsblog.blogspot.com/2012/02/what-does-keynesian-mean.html).